Conflict scenario in the Korean peninsula – how would it affect your business in the Middle East?

Newsletter

Conflict scenario in the Korean peninsula

14 Dec 2017

North Korea

Creating a Resilient Organisation

Sorana Parvulescu

Middle East Risk Watch - Issue 8 - December 2017
Conflict scenario in the Korean peninsula – how would it affect your business in the Middle East?

Recent electoral surprises, natural hazards and geopolitical disruptions across the world have tested our assumptions as business leaders and the preparedness of our organisations to respond to such changes. Many of these disruptions have occurred with little notice and were difficult to forecast, so rather than trying to gaze into a crystal ball, our responsibility as business leaders is to understand potential scenarios that our organisations may face and ensure that we are prepared to withstand whatever challenges come our way.

To support this effort, Control Risks and our partners at Oxford Economics are working through different geopolitical developments to assess how low-likelihood, high-impact scenarios could affect the economic and business environment in which we operate.

One of these developments has been the recent aggressive rhetoric between the US and North Korea, which has prompted questions over whether a conflict is likely in the Korean peninsula. In this article we build a scenario of how such a conflict could develop and we assess, together with our partners at Oxford Economics, the economic, business and geopolitical impact on companies operating in the GCC and the wider Middle East.

While unlikely, even a contained conflict in the Korean peninsula would shave 0.4pp off global economic growth and 0.5pp off GCC economic growth in 2018.

High stakes

An all-out conflict on the Korean peninsula remains unlikely, given the mutually assured destruction that it would entail for both North and South Korea. However, the risk of miscalculation is growing amid increased military activities and provocations by Pyongyang and Washington. The latter has in recent months increased aerial and naval patrols, including joint drills with Seoul, as a show of force. The US has dispatched an aircraft carrier to South Korea and on 21 October deployed two bombers near North Korea. In response, Pyongyang is likely to conduct further missile launches in the coming weeks to signal its displeasure. At the same time, other factors underpinning the erstwhile foreign policy positions of each side have been shifting. On the North Korean side, there are mounting questions regarding the extent of Kim Jong-un’s grip on power, given his alleged poor health, his refusal to make trips abroad and his repeated purges of high-level officials. This raises the stakes of potential instability in the case of a succession or of an impulsive foreign policy decision as a result of mounting domestic pressure. On the US side, the unnecessary inflammatory comments made by President Donald Trump, as well as apparent lack of a coherent policy towards North Korea within the administration, may prompt an ill-calculated move by North Korea, which in turn would push the US administration to respond in force to save face and credibility. China, Japan and South Korea will continue diplomatic efforts to avoid an all-out conflict, but the stakes are higher than they have been in recent years and the chances of a miscalculation have increased.

So, while a conflict remains unlikely, what would happen if it did occur? How would that scenario develop and what would be the economic and geopolitical consequences at the global level and for the GCC region in particular?

Conflict scenario

A conflict scenario assumes that a localised exchange of fire triggers a short-lived conflict in which the south, with the support of US air strikes, defeats the north in a matter of months. The conflict is contained and does not involve pre-emptive use of nuclear weapons, but significant loss of life and destruction of physical assets occurs on both sides of the demarcation zone, including significant damage in Seoul and south of the capital, as well as in South Korean industrial areas. Cyber attacks by the north against critical infrastructure in the south would add to disruption. The conflict would also require significant financial and military support from the US, South Korea and potentially Japan. Although China would be unlikely to intervene directly, uncertainty and disagreements over the future of a post-Kim North Korea would lead to a period of heightened tensions between the US and China. The shock to financial markets would spread beyond the region, amid increases in global financial market volatility and emerging market risk premiums.

Transmission channels

While the conflict would remain contained to the Korean peninsula, it would cause a ripple effect in the global economy through several transmission channels:

A hit in economic confidence and major market movements (equity and currency) at the outbreak of the conflict, which would spill over to economies around the world through trade and financial linkages.

A significant, albeit potentially short-lived, disruption to supply chain channels from and into South Korea.

Elevated risk premiums in the region.

Impact on global economy

The global economic and market impact of such a conflict would be significant, particularly in the near term. Overall, world GDP growth would remain subdued at 2.6% in 2018 and 2019 (compared with 3% and 2.8% respectively in Oxford Economics’ baseline forecast), 0.4pp below our baseline forecast, i.e. 2.6% in 2017, 2018 and 2019. Confidence would pick up strongly thereafter, with the level of world GDP converging towards baseline in the outer years. The initial economic impact would be felt most by South Korea, Japan and China. In these countries, the level of GDP would fall by more than 1.5% below baseline by 2019. There are also significant implications for trading partners in the region and we could see US and eurozone growth slowing, though much more modestly.

Impact on GCC economy

Moving from the global context to the GCC, the main transmission channels of a Korean conflict for GCC economies would be through a lower oil price and a slowdown in key trading partners. Oxford Economics assumes that oil prices would drop slightly below baseline due to lower demand, especially from emerging Asian economies at the centre of the conflict, but also from advanced economies.
The conflict would result in a slight slowdown in real GDP growth in GCC economies, approximately 0.5pp of growth in 2018, but would push down inflation as a result of a global slowdown, lower commodity prices and increased geopolitical tensions.

Geopolitical and business impact on the Middle East

Beyond its macroeconomic impact, such a scenario would also affect the geopolitics of the Middle East and on day-to-day business operations in the region.
On the geopolitical front, the key transmission channels would be a shift in the US’s attention away from the Middle East in terms of its foreign policy and a shift in the commercial interest of Asian companies towards reconstruction efforts in the Korean peninsula.

The first transmission channel could have far-reaching implications for regional stability. On the upside, it could provide a lifeline for the nuclear deal with Iran should the US Congress decide that having two potentially rogue nuclear states on the US’s current foreign policy agenda is excessive. This would help avoid a situation in which Iran is pushed by the US to retreat back into an isolationist, aggressive foreign policy posture in the region. On the downside, a major focus of US foreign policy and its military in the Korean peninsula would potentially see it dial down efforts to act as a mediator and security guarantor in major disputes across the Middle East, including Iraq and Qatar, increasing the risk that these disputes could escalate and continue to destabilise the region. Countries in the Middle East – and particularly in the GCC – would be likely to respond to a growing disengagement by the US by seeking to forge stronger alliances with Eastern powers, including China, Russia and India, in terms of both defence and commercial cooperation.

The second transmission channel could see reconstruction effort in the Korean peninsula diverting the attention and investment of key Asian players, particularly Japan, away from the Middle East. Given the size and breadth of investment commitments of such companies in the region, this could have a snowball downward effect on economic activity and diversification plans across the Middle East and in the GCC in particular.

In terms of the impact on business operations, a conflict scenario would have a direct impact on any business with operations in South Korea or the broader region. Companies with personnel in the region need to monitor a combination of triggers that could signal a worsening of the situation that would prompt them to activate their evacuation plans. However, other consequences would be relevant for companies with no presence in the Korean peninsula itself. First, companies in the Middle East would be likely to be affected by supply chain disruptions caused by a conflict – not just in South Korea, but also in neighbouring countries, such as China, and in shipments across the South China Sea. Second, additional US or UN sanctions against Chinese companies dealing with North Korea (which remain likely even in the absence of a conflict) would require businesses dealing with China to ensure that they monitor such sanctions regimes and remain compliant with international legislation.

What can you do to prepare for such a scenario?

Although a conflict in the Korean peninsula remains a low likelihood scenario, it is best practice to at least consider such potential disruptions when discussing the preparedness and resilience of your business to geopolitical shocks. We make five recommendations below on how you can do that.

Map your exposure to the Korean peninsula in terms of people, assets and supply chain.

Run regular scenario exercises to test your organisation’s preparedness and improve its potential to respond to and recover from disruption.

Monitor sanctions regimes and run due diligence on your Chinese third parties to keep in line with the evolving sanctions legislation.

Monitor regional developments and develop a set of triggers that would prompt a change in your approach to the above.

Entering a new market or adopting a new project is often challenging. It is not simply a question of being able to complete the project or not, but one of delivering genuine growth for the business and mitigating against any potential risks you might encounter.